Can You Buy a Bond That Keeps Pace with Inflation?
The word “inflation” has returned to people’s vocabulary. Your client probably feels the impact when they shop for groceries; everything seems to cost more. Meanwhile, the rate of return on their money market account or bank Certificates of Deposit doesn’t keep pace with the price increases they are seeing. Is there a way to put money aside that will keep pace with inflation?
The Problem with Fixed Income Investments
As an accountant, you are familiar with the expression “fixed income.” Some of your retired clients probably live on a fixed income. They might collect their income from a pension plus Social Security. Unless there is a cost-of-living adjustment (COLA) feature, their pension payments stay the same. Fortunately, Social Security has the COLA feature. Annuities might not, unless they have a cost-of-living rider. The problem is the cost of living tends to go up more quickly than your client’s income, if it rises much at all.
Issuing bonds makes sense for businesses, municipalities and governments because they can borrow money now and pay it back with cheaper dollars later. Cheaper dollars? The purchasing power of a dollar will be less 30 years from now because of the impact of inflation.
Let’s Talk About Plain Vanilla Treasury Bonds
The federal government traditionally borrows money by issuing treasury notes and bonds on a regular basis. They have a principal value and a coupon rate. A $1,000 bond returns your $1,000 on the maturity date and pays coupon interest every six months. Treasury Bills are short term and are sold at a discount to face value. Put another way, you buy them at a slight discount and collect $1,000 at maturity. Treasury Bills mature in one year or less, treasury notes between one to 10 years and treasury bonds between 10 and 30 years. The interest from treasuries is taxable at the federal level, but exempt from state and local taxes.
Let’s Talk About Inflation Protected Bonds
The U.S. Treasury also issues bonds that offer a degree of protection against inflation. They come in two types.
Series I Bonds. Do you remember Series EE savings bonds? Decades ago, grandparents would buy them as a present for newborn babies. They were sold in $25 increments. You bought them from a bank. They came in certificate form.
Series I savings bonds are an updated version. They come in $25 increments. You can buy them directly from the U.S. Treasury through the TreasuryDirect website. More on rules and restrictions later.
You make your money in two ways. There is a fixed coupon rate of interest and an inflation adjustment to the principal. The coupon rate is nominal. It may be close to zero. The major benefit is the inflation adjusted return to your principal. For Series I Bonds purchased between May 2022 and November 2022 the combined rate is 9.62 percent.
Series I savings bonds have a 30-year maturity. You only see the coupon rate, which at the moment is zero percent. However, the payment based on inflation is added to your principal. This means your interest is effectively reinvested and compounded semiannually, when interest is credited in May and November. The interest rate is recalculated for each six-month interval.
There are several restrictions. You can only buy $10,000 worth of Series I savings bonds a year. If you choose to direct your federal tax refund in Series I savings bonds, you can put another $5,000 away. This involves filing IRS form 8888.
These bonds are not for short-term investors. They must be held for at least one year before they can be redeemed. If you redeem them between one year but less than five years, you incur a penalty of three months’ interest.
There is another benefit, the education exclusion. If the money is used for paying for higher education, you are exempt from Federal income tax. You can see the benefits for college planning.
Treasury Inflation Protected Securities (TIPS). TIPS are similar to Series I bonds, but with less restrictions. They can be bought and sold similar to U.S. Treasury bonds. They come with maturities of five, 10 and 30 years. They can be bought through TreasuryDirect or through financial services firms. Some firms have packaged these securities as mutual funds or exchange traded funds (ETFs). Put another way, clients can buy them directly from the U.S. Treasury, through an intermediary or packaged.
TIPS earn interest similar to Series I bonds. You have a coupon rate, which is set at the auction when your TIPS is created. That stays the same for the life of the security, until the maturity date. When the inflation adjustment is made, the extra money is applied to your principal amount. Assuming inflation is a positive number, when your coupon rate of interest is paid out, it is based on the new value of your underlying principal.
Deflation poses a risk. If inflation becomes negative, this works against you because the value of your principal can be adjusted downwards. However, the value of your principal can never decline below the starting amount, the face value when the security was created at auction.
TIPS have a minimum holding period of 45 days. After that, they can be sold at the current market price anytime or held to maturity.
Interest earned on TIPS is taxable at the federal level and exempt from state and local taxes. This applies to both the coupon interest you collect along the way and the interest credited towards your principal through the inflation adjustments.
If your client is concerned about how their savings can keep pace with inflation, inflation-protected bonds issued by the federal government may be a good option to consider.